Big Oil likely to be leaner

Houston ChronicleMidland Reporter-Telegram

Published 6:00 pm, Saturday, January 31, 2009

By Kristen Hays

Houston Chronicle

The party's over for Big Oil.

That may not be immediately evident as the world's largest publicly traded oil majors reveal their annual 2008 profits in the coming days. Crude's wild ascent into triple digits for most of last year paves the way for yet another string of record annual earnings.

But oil's swift fall in late 2008 paints a starkly different picture for those last three months and possibly well into 2010, depending on when economic recovery begins eclipsing the worst recession in decades.

"The air has gone out of the tires, the wind's gone out of the sails," said John Olson, an analyst with Sanders Morris Harris in Houston.

ConocoPhillips will lead off earnings announcements, followed by Royal Dutch Shell, Exxon Mobil Corp. and Chevron Corp. BP, Marathon Oil Corp. and the largest independents will report in early February.

Unlike its peers, ConocoPhillips already alerted investors to its plan to slim down in response to lower oil and natural gas prices, including impending layoffs, asset value write-downs, shrunken capital spending and a significant hit on reserves.

While at least some of the other majors may ride out the recession with flat spending and few layoffs, except among contractors, analysts expect consistent announcements of lower profits and reserve write-downs.

"It's going to be more of the same," said Fadel Gheit, an analyst with Oppenheimer & Co. "We have been through the fat years. Now we're going through the lean years."

Through the year, CreditSights analysts expect earnings for the majors to fall by 68 percent while net income for independents, with exploration and production but no refining or chemicals operations, will fall 48 percent.

Trouble on all sides

In this environment, integrated oil companies with exploration and production, refining and chemical operations face recession-driven troubles on all sides.

Lower oil and natural gas prices siphon profits from exploration and production, particularly expensive operations like those in Canada's oil sands or in the Gulf of Mexico's deepest waters.

Refinery profits were squeezed when oil hit unpre-cedented highs last year because high prices depressed refining margins - the difference between what refiners pay for crude and what they can get for products made from it including gasoline. Now demand is down amid the recession, which could overshadow efforts to capture better margins by cutting costs, reducing inventories and shifting production from gasoline to diesel for export, CreditSights said in a report.

And stand-alone chemical makers illustrate that industry's struggles with production cuts, layoffs and plant closings amid a lower demand for goods that contain their products. Some have filed for bankruptcy protection.

Analysts say once investors look past annual profits for 2008 and see quarter-to-quarter comparisons, they'll see the direct effect of the fall in oil and natural gas prices.

"The best barometer of future prosperity and layoffs will be the price of crude oil," Olson said.

'Far-reaching'

Gheit said the squeeze comes from operational costs that haven't fallen as swiftly as oil and natural gas prices, which will reduce earnings to their lowest levels in five years. Asset value write-downs emerge for investments recorded before the market declined. And reserves write-offs will come because under current Securities and Exchange Commission rules, companies can only book reserves that can be economically recovered at the closing price on the last trading day of the previous year.

"Earnings will be dismal. They're all under pressure to cut costs. The sharp drop in oil and gas prices has tremendous far-reaching ramifications on the landscape," Gheit said.

The closing price of crude on the last trading day of 2008 was $44.60 - less than half of the $95.98 price on the last trading day of 2007, according to the U.S. Energy Information Administration.

Key indicator

With operational costs still high, the difference in price will force companies to book fewer reserves, shrinking the reported rate at which they replace the crude and natural gas they produce.

Analysts view that rate as a key gauge of a company's future strength.

ConocoPhillips said its reserve replacement rate will be 25 percent to 30 percent. Excluding the effects of lower crude prices, the rate would have been 80 percent to 85 percent, reflecting more expensive-to-recover reserve additions from exploration as well as acquisitions.

Fitch Ratings said in a recent report that the reserves write-downs shouldn't significantly affect cash on hand or spending plans for majors or independents with strong credit ratings. Those that rely on reserves to help get loans, however, could see their borrowing capacity shrink with credit markets so tight.

Reporting reserves

The SEC this month approved changes in reserves reporting rules that could ease the volatility of price swings in the future. The changes include a requirement that companies, starting next year, use a 12-month average price rather than the single-day year-end price.

Had that change been in place for 2008, companies could have used the year's average of about $99 a barrel in calculating reserves.

Companies are expected to point to the change as a "ray of hope" that could bolster reserves this year, Bernstein Research analyst Neil McMahon said in a recent report.

But the ray may not be too bright, Credit Suisse analyst Mark Flannery said in a report examining Conoco-Phillips' revelations.

"Average commodity prices in 2009 are almost certain to be lower than the average of 2008, keeping some of the written-down reserves uneconomic, particularly in more mature areas," he said. "In other words, not all of the 2008 price-related reserve write-downs will be written back at the end of 2009 using the new rules."